Equity risk is "the financial risk involved in holding
equity
Equity may refer to:
Finance, accounting and ownership
* Equity (finance), ownership of assets that have liabilities attached to them
** Stock, equity based on original contributions of cash or other value to a business
** Home equity, the dif ...
in a particular investment." Equity risk often refers to equity in companies through the purchase of stocks, and does not commonly refer to the risk in paying into real estate or building equity in properties. Equity risk is a type of market risk that applies to investing in shares. The market price of stocks fluctuates all the time, depending on supply and demand. The risk of losing money due to a reduction in the market price of shares is known as equity risk.
The measure of risk used in the equity markets is typically the standard deviation of a security's price over a number of periods. The standard deviation will delineate the normal fluctuations one can expect in that particular security above and below the mean, or average. However, since most investors would not consider fluctuations above the average return as "risk," some economists prefer other means of measuring it.
Equity risk premium (ERP) is defined as "excess return that an individual stock or the overall stock market provides over a risk-free rate."
equity risk premium (ERP)is the difference between the return on a market portfolio or a stock with average market risk and the risk-free rate of return. From this definition, it is clear that the market average equity return is the expected "threshold" for investors to engage in investment activities in the market, and if the current return is lower than the average return, rational investors will abandon it in favor of higher yielding investments. Also, the average market return is an ex-ante expected return, which means there may be a difference between ex-ante expectations and ex-post values.
The level of risk is closely proportional to the equity risk premium. The wider the difference between the stock's return and the risk-free rate, and thus the higher the premium, the higher the risk. The equity risk premium can also be used as a portfolio indicator by investors. According to Gaurav Doshi, CEO of IIFL Wealth Portfolio Managers, the bigger the equity risk premium, the more probable investors will shift their portfolios away from bonds and toward equities. In the long term, any investor that takes a bigger risk is rewarded.
This excess compensates investors for taking on the relatively higher risk of the equity market. The size of the
premium
Premium may refer to:
Marketing
* Premium (marketing), a promotional item that can be received for a small fee when redeeming proofs of purchase that come with or on retail products
* Premium segment, high-price brands or services in marketing, ...
can vary as the risk in the
stock
In finance, stock (also capital stock) consists of all the shares by which ownership of a corporation or company is divided.Longman Business English Dictionary: "stock - ''especially AmE'' one of the shares into which ownership of a company ...
, or just the
stock market
A stock market, equity market, or share market is the aggregation of buyers and sellers of stocks (also called shares), which represent ownership claims on businesses; these may include ''securities'' listed on a public stock exchange, as ...
in general, increases. For example, higher risks have a higher premium. The concept of this is to entice investors to take on riskier investments. A key component in this is the risk-free rate, which is quoted as "the rate on longer-term government bonds." These are considered risk free because there is a low chance that the government will default on its loans. However, the investment in stocks isn't guaranteed, because businesses often suffer downturns or go out of business.
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Over the long term, the equity risk premium forecasts that equities would outperform risk-free investments. By deducting the projected expected return of risk-free bonds from the estimated expected return of stocks, the risk premium can be calculated. For example, if the return on a stock is 17% and the risk-free rate over the same period of time is 9%, then the equity-risk premium would be 8% for the stock over that period of time.
Some analysts use "implied equity risk premium," a forward-looking view of ERP. To calculate the implied equity risk premium for the market, one would forecast an expectation of future market returns and subtract the risk-free rate appropriate for the forecasting period.[http://people.stern.nyu.edu/adamodar/podcasts/valspr15/valsession5.pdf ]
Importance:
-Favors investments in
1. Helps in the selection of financial assets. In individual asset selection, investors can make asset allocation decisions, i.e. how to allocate their funds to equities, fixed income bonds or other assets, based on the relevant risk and return estimates obtained and comparing the level of risk premiums of various assets, which helps to improve the efficiency of investors' decisions.
2. It helps project investment analysis. In project investment, the Capital Asset Pricing Model (CAPM) is usually used to calculate the expected rate of return of a project.
-Facilitates forecasting
ERP usually determines the expected return on common stock. If ERP decreases, the discount rate of the investment decreases and causes the stock price to increase. The stock market is a leading indicator of macroeconomic performance, so by determining the trend of the ERP and stock price movements in the stock market, macroeconomic trends can be predicted.
See also
*Risk premium
A risk premium is a measure of excess return that is required by an individual to compensate being subjected to an increased level of risk. It is used widely in finance and economics, the general definition being the expected risky return less t ...
References
{{Financial risk
Risk
In simple terms, risk is the possibility of something bad happening. Risk involves uncertainty about the effects/implications of an activity with respect to something that humans value (such as health, well-being, wealth, property or the environme ...
Market risk